An Interview with NYU Stern School of Business Professor Itamar Drechsler on the Eurodebt Crisis
Problems continue in Europe, especially in countries like Greece and Spain, where we see record high unemployment rates. What are the central issues that are still preventing Europe from solving their problems?
“There are a couple of problems and they are clearly related. One, is that there are a lot of banks in Europe and it’s not clear what their problem is exactly. Some people believe there is a general banking liquidity crisis. For example, one thing that’s out there is that many people are afraid that certain banks won’t survive and so they pull their money out of those banks, which of course, makes it so [the banks] won’t survive. So, there is a slow bank run going through Europe, where the countries that are weaker – their banking systems are slowly failing and, of course, a banking crisis is very bad for an economy, because it means businesses can’t borrow and people don’t have anywhere to save and we know that is a disaster.”
“The question is – is there enough intervention to lend them enough money that is going to fix it? I think the solutions that you hear have a lot of times been – ‘let’s lend them more’ and ‘let’s lend them against any kind of collateral they want.’ One impression that it hasn’t fixed things, is that it doesn’t look like that is changed so much. Even after being lent this money, they are fundamentally broke, so they cannot be fixed without a recapitalization or having them be taken over and if they don’t, they kind of have basic problems with the way that they manage their business. When you’re kind of on the verge of broke, you run your business usually in a suboptimal way. You’re kind of gambling for the upside, rather than necessarily doing what is the right thing to maximize value during normal times, so that can kind of make the problem worse and make the problem go on for longer.”
Do you think the issues with the banks are the underlying problem?
“I think it is a bad problem because the way you look at it is – how did this start? There’s some problem that drew all these things to this place and that has been going on for a long time. People claim that the periphery in Europe is not competitive, but now we’re talking about taking this thing back a long way – labor costs in the periphery are much higher than they are in Germany, people are less productive, they make a lot more money per whatever they are producing than they do in Germany and that seems to be clear. It seems like for quite a while, maybe a decade, unit labor costs in these countries are going up, whereas Germany has done a lot to make itself more competitive. At some point, they become very uncompetitive, but you didn’t see it in their output or in people’s consumption. One reason may be is that these governments borrowed more and more and kind of propped up the local economy by spending money that they borrowed, and they were able to borrow, and thought they were going to pay them back, and there’s a good question of why that went on for so long, but it ended at some point, 2009-2010, more than a year after the crisis. So now they’ve been cut off at borrowing money at cheap rates, so first that has caused a lot of problems internally because economies have contracted, they don’t pay as much taxes, so it makes them even more in debt and makes them have to issue money more expensively. At the same time, many of those issues really hurt the banks, so this is all very related. All these things were kind of going on with the financial crisis. These governments also often tried to help their banks, so now, they’re already kind of not competitive and borrowing too much and now they’re trying to help their banks, which is kind of loading debt on top of debt. The governments are in bad shape, the banks are in bad shape – these are not unrelated issues, and the economy is not in good shape, and again it is not unrelated.”
So you have these three related and interconnected entities stopping Europe from solving their problems?
“The question is what is the original one [problem]? Even saying that they’re not productive is not really an explanation. It’s a partial explanation. The question is why are they not productive? Why do they seem to have economies that are structurally not working as well as other places? These problems are related but they’ve kind of developed their own dynamics. You want to fix the banking problem before you try to fix some bigger productivity issue perhaps. Government can’t repay and banks already own a lot of the debt, so now you can’t fix the banking problem without fixing the sovereign problem and how are they going to pay their taxes if they are not competitive? These are all very related to each other. I don’t know whether to call these things different or not. Certainly, people talk about them in their own groups, but the sovereign and the banking problem are clearly tightly connected together.”
How can the Eurozone countries better align on the critical fiscal issues?
“There are a lot of problems. There are political issues and it’s also about what people are willing to accept. What is being sold, in some sense to the Germans, but they are not buying it completely, is with fiscal integration, essentially if they take on some of the debt of other countries, they’ll be able to get out of this crisis and that will be better for Europe then to break it up right now. Some people are saying ‘this is a failed experiment, we don’t want their debt, it’s not going to fix things’.”
So the problem is that these countries are all so politically different?
“Even internally, within a given country. Take Greece for example – very high government employment, very low government labor productivity, many people evade taxes, the tax law is not well enforced. You want to fix the problem, but then it gets into politics. You want to slash somebody’s wages and retirement. They will say, ‘I don’t want to be the one here, those guys first.’ Everybody’s trying to protect their own interests and nobody wants to be the first one to give up what they have. You want to do labor reforms in Italy – you’re always going to slash and take from somebody, maybe everybody, but nobody wants to be the one to give it up, so they fight for what they have, understandably, but it’s a terrible problem, and it’s very hard to make these reforms.”
So what will happen? Do you think it is likely to see the Eurozone go back to the core six countries?
“I don’t know, I think anything is possible. These things always look impossible until they happen. Anything is possible. I think they’re trying not to get there pretty hard. I think at the end of the day, that bluff will be called. I’m not a European, I don’t know how they feel. I can see the Germans are very angry. The French want them to do fiscal integration, but they’re not really buying it. They spent a lot of years keeping wages down in German manufacturing and they’ve sacrificed a lot to get here. It’s not like they are super rich. They’ve done well, they’ve worked very hard, the unions have been forced to give up a lot there, and they feel like they’re already paying for it, because they lent this money and it’s not going to be repaid back to them in full, but they sometimes pretend that if they just press hard enough, it’s going to be, but it seems clear that it won’t.”
Do you think the EMU was created too quickly, rushed into, and wasn’t integrated correctly from the onset?
“The Maastricht Treaty and this convergence of Europe to a single currency was actually a very long-term process. It’s easy to call it a bad idea, but I think one of the puzzles is if you asked a bunch of economists, what is the right way to set up borrowing in such a union, I think the theoretical answer most people would have given you, is that you actually shouldn’t, you don’t want to issue common debt – you want to let each country issue its own debt and then the market will discipline them because it would see which countries are responsible, which will raise the borrowing costs for those that look irresponsible and, therefore, force them to cut back on their spending. That is exactly what we did. Somehow, the market let different countries pile up a lot of debt before that happened. If you really asked people honestly and if you never showed them what happened, and you asked them, how should we do it? They would tell you the way we did it. So is it rushed? I think that’s the answer people would have told you, but somehow that device failed and given that it failed, then you get into a situation where many people have a strong interest not to let any given country, even a small country like Greece fail.”
So maybe there was no better way of doing things?
“Clearly, this didn’t work, so I wouldn’t say that, but it would have been hard to foresee. There were well-known people that criticized this. There’s even an interesting article that Chris Sims, who was a Nobel Prize winner last year, wrote in 1998-1999. He kind of criticized a lot of these things, it looks a lot like what happened, but there’s always somebody saying that something is not going to work or it is going to work. He criticized the fact that every country gets to keep its own central bank as an important regulatory function.”
So, as you can see, it clearly is not the end of the story on Europe and there is likely to be many more twists and turns before the Eurozone countries are able to better align and fix their problems once and for all.